Thursday, June 29, 2017

Speculative booms are often poor guides to future valuations and the maturation trajectory of a new sector.

I recently came across a December 1996 San Jose Mercury News article on tech pioneers’ attempts to carry the pre-browser Internet’s bulletin board community vibe over to the new-fangled World Wide Web.

In effect, the article is talking about social media a decade before MySpace and Facebook and 15 years before the maturation of social media.

(Apple was $25 per share in December 1996. Adjusted for splits, that’s about the cost of a cup of coffee.)

So what’s the point of digging up this ancient tech history?

-- Technology changes in ways that are difficult to predict, even to visionaries who understand present-day technologies.

-- The sources of great future fortunes are only visible in a rearview mirror.

Many of the tech and biotech companies listed in the financial pages of December 1996 no longer exist. Their industries changed, and they vanished or were bought up, often for pennies on the dollar of their heyday valuations.

Which brings us to cryptocurrencies, which entered the world with bitcoin in early 2009.

Now there are hundreds of cryptocurrencies, and a speculative boom has pushed bitcoin from around $600 a year ago to $2600 and Ethereum, another leading cryptocurrency, from around $10 last year to $370.

Where are cryptocurrencies in the evolution from new technology to speculative boom to maturation? Judging by valuation leaps from $10 to $370, the technology is clearly in the speculative boom phase.

If recent tech history is any guide, speculative boom phases are often poor guides to future valuations and the maturation trajectory of a new sector.

Anyone remember “push” technologies circa 1997? This was the hottest thing going, and valuations of early companies went ballistic. Then the fad passed and some new innovation became The Next Big Thing.

All of which is to say: nobody can predict the future course of cryptocurrencies, other than to say that speculative booms eventually end and technologies mature into forms that solve real business problems in uniquely cheap and robust ways no other technology can match.

So while we can’t predict the future forms of cryptocurrencies that will dominate the mature marketplace, we can predict that markets will sort the wheat from the chaff by a winnowing the entries down to those that solve real business problems (i.e. address scarcities) in ways that are cheap and robust and that cannot be solved by other technologies.

The 'Anything Goes' Speculative Boom

Technologies with potentially mass applications often spark speculative booms. The advent of radio generated a speculative boom just as heady as any recent tech frenzy.

Many people decry the current speculative frenzy in cryptocurrencies, and others warn the whole thing is a Ponzi scheme, a fad, and a bubble in which the gullible sheep are being led to slaughter.

Tribalism is running hot in the cryptocurrencies space, with promoters and detractors of the various cryptocurrencies doing battle in online forums: bitcoin is doomed by FUD (fear, uncertainty and doubt) about its warring camps, or it’s the gold standard; Ethereum is either fundamentally flawed or the platform destined to dominate, and so on.

The technological issues are thorny and obtuse to non-programmers, and the eventual utility of the many cryptocurrencies is still an open question/in development.

It’s difficult for non-experts to sort out all these claims. What’s steak and what’s sizzle? We can’t be sure a new entrant is actually a blockchain or if its promoters are using blockchain as the selling buzzword.

Even more confusing are the debates over decentralization. One of the key advances of the bitcoin blockchain technology is its decentralized mode of operation: the blockchain is distributed on servers all over the planet, and those paying for the electricity to run those servers are paid for this service with bitcoin that is “mined” by the process of maintaining the blockchain. No central committee organizes this process.

Critics have noted that the mining of bitcoin is now dominated by large companies in China, who act as an informal “central committee” in that they can block any changes to the protocols governing the blockchain.

Others claim that competing cryptocurrencies such as Ethereum are centrally managed, despite defenders’ claims to the contrary.

Meanwhile, fortunes are being made as speculators jump from one cryptocurrency to the next as ICOs (initial coin offerings) proliferate. Since the new coins must typically be purchased with existing cryptocurrencies, this demand has been one driver of soaring prices for Ethereum.

As if all this wasn’t confusing enough, the many differences between various cryptocurrencies are difficult to understand and assess.

While bitcoin was designed to be a currency, and nothing but a currency, other cryptocurrencies such as Ethereum are not just currencies, they are platforms for other uses of blockchain technologies, for example, the much-touted smart contracts. This potential for applications beyond currencies is the reason why the big corporations have formed the Enterprise Ethereum Alliance (https://entethalliance.org/).

Despite the impressive credentials of the Alliance, real-world applications that are available to ordinary consumers and small enterprises using these blockchain technologies are still in development: there’s lots of sizzle but no steak yet.

Who Will The Winner(s) Be?

How can non-experts sort out what sizzle will fizzle and what sizzle will become dominant? The short answer is: we can’t. An experienced programmer who has actually worked on the bitcoin blockchain, Ethereum and Dash (to name three leading cryptocurrencies) would be well-placed to explain the trade-offs in each (and yes, there are always trade-offs), but precious few such qualified folks are available for unbiased commentary as tribalism has snared many developers into biases that are not always advertised upfront.

So what’s a non-expert to make of this swirl of speculation, skepticism, tribalism, confusing technological claims and counterclaims and the unavoidable uncertainties of the exhilarating but dangerously speculative boom phase?

There is no way to predict the course of specific cryptocurrencies, or the potential emergence of a new cryptocurrency that leaves all the existing versions in the dust, or governments’ future actions to endorse or criminalize cryptocurrencies. But what we can do -- now, in the present -- is analyze present-day cryptocurrencies through the filters of scarcity and utility.

In Part 2: The Value Drivers Of Cryptocurrency, we analyze the necessary success requirements a cryptocurrency will need to excel on in order to become adopted at a mass, mainstream level. Once this happens (which increasingly looks like a matter of "when" not "if"), the resultant price increase of the winning coin(s) will highly likely be geometric and meteoric.

Sadly, the most probable catalyst for this will be a collapse of the current global fiat currency regime -- something that increasingly looks more and more inevitable. This will destroy a staggering amount of the (paper) wealth currently held by today's households. Which makes developing a fully-informed understanding of the cryptocurrency landscape now -- today -- an extremely important requirement for any prudent investor.

What is complexity in this context? More organization, more layers of management, higher levels of specialization, an expansion of roles and differentiated areas of expertise, more channels of communication, more feedback loops, and an increase in the quantity and types of communication.

All of which consumes more energy and more treasure, not just to build the infrastructure of this increased complexity but to train the staff and maintain the higher costs going forward.

Which raises the obvious question: how does increasing cost solve anything? Doesn't increasing the cost of a system create the problems resulting from taking money from some other source to pay the higher costs?

There are several different answers to this question.

1. The problem that must be solved is an existential threat to the society, and therefore cost is no longer an issue. World War II offers a historical example of an existential threat requiring a vast expansion of complexity and cost.

The upside of this dynamic is the problem is resolved relatively decisively by either victory or defeat. The downside is the vast sums borrowed to fund the war effort must be paid, or at least the interest must be paid--or the enormous debts must be renounced, crippling trust and the credit system.

2. The gains reaped by increasing complexity more than offset the higher costs. Amazon seems to offer a commercial example of this dynamic. By investing heavily in complex technology, Amazon has created financial incentives for consumers to shop online and have their purchases delivered to their door.

Consolidating consumption is this fashion lowers costs in many ways. Instead of 100 consumers getting in 100 vehicles and driving to a mall/retail center, a handful of delivery vehicles distribute the purchases, reducing energy consumption, air pollution, traffic congestion, fuel burned while waiting in traffic, etc.

The increased complexity of online shopping and delivery has impacted the higher fixed-cost bricks and mortar retail sector, as this higher cost shopping-distribution system is experiencing stagnant sales and plummeting profitability.

3. The initial costs of increasing complexity are offset by lower operating and maintenance costs. With the costs of labor and labor overhead (healthcare and pension costs) rising, investments in automation complexity may reduce operational expenses significantly, more than offsetting the costs of increasing complexity via automation.

But many of the increases in complexity in our socio-economic system aren't intended to solve existential or cost problems; they're designed to address political issues or to foster perceptions that problems are being addressed.

Many increases in complexity are intended to reduce exposure to liability--legal threats that increase operational costs without offering much in the way of offsetting benefits.

Increasingly complex laws and regulations are passed to mitigate politically pressing issues, and the pressure on politicians and regulators to "do something" leads to regulatory and legal thickets that may well have limited impact on the problem but serve to signal to constituencies that "your problem has been addressed."

The added costs of this complexity are rarely considered in the political process, which focuses on easing the short-term pain of political pressure.

Another source of increasing complexity that yields diminishing returns is institutions and agencies whose raison d'etre is to generate and enforce regulations. These agencies must continually produce more regulations to justify their budgets and staffing, and adding systemic costs is not an issue.

The regulatory institutions have no mechanisms, processes or incentives to reduce systemic complexity or accurately assess the costs of increasing regulatory burdens.

This incremental increase in systemic complexity is rarely if ever recognized as a problem that additional complexity can't solve. In solving liability, regulatory and political issues with added layers of complexity (that created more complexity as they interact in unexpected ways), we have increased the systemic load of complexity in ways that may only become visibly destabilizing when the system stops working or slides into insolvency.

Why is insolvency a potential result of rising complexity? Rather than pay the higher costs by taking funding from other programs--a politically risky move, as those whose funding has been cut will ignite a political firestorm of protest--our political "leadership" has borrowed the costs of increasing complexity from future earnings and future taxpayers.

All borrowed money accrues interest, and eventually the mountain of debt crushes the economy by either bleeding investment and consumption to pay the interest or by destroying the purchasing power of the currency as the government inflates away the debt by debauching its currency.

What problems are we solving by increasing systemic complexity? What problems are we exacerbating by adding systemic complexity? We'll know the answer when systems start breaking down and a stark choice between destroying the purchasing power of our currency or insolvency presents itself.

Tuesday, June 27, 2017

My friend G.F.B. recently coined an insightful maxim: Proximity Is Destiny. The power of this concept lies in its unification of physical proximity and abstract proximity.

We all understand physical proximity can be consequential. As the Titanic settled lower in the ice-cold Atlantic, those close enough to the lifeboats to secure a seat (mostly the first and second class passengers) lived and those who were not died.

College graduates seek internships at the most successful companies because they know the connections they make by working within the headquarters might lead to a job offer: physical proximity to movers and shakers (and those with the power to hire) is destiny.

But proximity to abstract manifestations of power is even more consequential in an economy/society in which wealth and power are predominantly abstract.For example, getting an internship in the Federal Reserve doesn't mean you can obtain proximity to the Fed's money/credit spigot as a result of your physical proximity to the building or staff: the really powerful proximity--being close to the Fed's money/credit spigot--is entirely abstract.

Abstract proximity is structural, and often invisible. We can't discern an individual's proximity to money/ credit/ privileged-information spigots by their physical locale or appearance, though we may infer their income/wealth from various status signifiers.

But signifiers don't tell us much about abstract proximity. Two individuals may own the same status signifiers, but one earned them the hard way, and the other had the advantage of proximity to insider information.

Privilege is much in the news recently, and I wrote a short book exploring the nature of privilege: Inequality and the Collapse of Privilege. The point of the book is this: privilege requires a centralized power hierarchy, as only a centralized power hierarchy can impose or nurture privilege, often through informal power structures.

Privilege is unearned proximity to power in all its manifestations: in our world of abstract structures of power, privilege often appears informal, masking its structural nature.

This informality enables a useful (to the privileged) confusion of privilege and merit. Two individuals may appear to enjoy similar status--both own homes in upscale neighborhoods, drive luxury vehicles, vacation in exotic locales, own second homes, belong to churches, temples, clubs, charitable organizations, etc. well-stocked with wealthy, influential people, etc., but the sources of their status are very different.

One was handed all this by family connections and inherited wealth, while the other worked his/her way up from humble beginnings. The individual who managed to work his/her way up the social-mobility ladder needed proximity to opportunity, and might have been helped by mentors and plain old luck, but privilege played a relatively modest role in the journey, as millions of other people with similar social status had roughly similar proximity to opportunity.

This inherent difficulty in differentiating privilege from merit allows the privileged Elites to claim their advantageous position is all due to merit: I worked harder than the other guy, etc., when in fact it was proximity to abstract privilege and power that lofted them to the top of the pyramid.

The Power Elites always have need for hard-working, smart, honest strivers to serve their enterprises and institutions, and so they recruit non-privileged strivers to their inner circles: prep schools, elite universities, prestigious organizations, the "right" church, temple, etc., internships in higher management, scholarships, foreign postings that serve to quickly advance careers, and so on.

This proximity is very close to what they offer their own offspring. But there's a difference, of course; their offspring can be dull-witted and lazy, and they will still get access to all these advantages.

And there is another unstated difference: the merely merit-based striver will not be invited to private gatherings, nor encouraged to find a mate in the Elite class.

Proximity is destiny, and it's proximity to abstract but very real structures of privilege, power and capital that count.

As I detailed yesterday, proximity to the flow of cheap credit creates fortunes, fortunes that aren't earned via merit, innovation, genius or the creation of new goods and services; proximity to cheap credit is the core dynamic of rentier skims based on the acquisition of income-producing assets.

With sufficient income and capital, you also gain proximity to the machinery of governance--our pay-to-play "democracy" in which influence can be bought to benefit the few at the expense of the many.

Proximity is destiny. To understand this, we must first illuminate the abstract structures that enable proximity to the abstract but oh-so-real levers of privilege, power, wealth and influence.

Monday, June 26, 2017

Everyone who wants to reduce wealth and income inequality with more regulations and taxes is missing the key dynamic: central banks' monopoly on creating and issuing money widens wealth inequality, as those with access to newly issued money can always outbid the rest of us to buy the engines of wealth creation.

History informs us that rising wealth and income inequality generate social disorder.

Access to low-cost credit issued by central banks creates financial and political power. Those with access to low-cost credit have a monopoly as valuable as the one to create money.

Compare the limited power of an individual with cash and the enormous power of unlimited cheap credit.

Let’s say an individual has saved $100,000 in cash. He keeps the money in the bank, which pays him less than 1% interest. Rather than earn this low rate, he decides to loan the cash to an individual who wants to buy a rental home at 4% interest.

There’s a tradeoff to earn this higher rate of interest: the saver has to accept the risk that the borrower might default on the loan, and that the home will not be worth the $100,000 the borrower owes.

The bank, on the other hand, can perform magic with the $100,000 they obtain from the central bank. The bank can issue 19 times this amount in new loans—in effect, creating $1,900,000 in new money out of thin air.

This is the magic of fractional reserve lending. The bank is only required to hold a small percentage of outstanding loans as reserves against losses. If the reserve requirement is 5%, the bank can issue $1,900,000 in new loans based on the $100,000 in cash: the bank holds assets of $2,000,000, of which 5% ($100,000) is held in cash reserves.

This is a simplified version of how money is created and issued, but it helps us understand why centrally issued and distributed money concentrates wealth in the hands of those with access to the centrally issued credit and those who have the privilege of leveraging every $1 of cash into $19 newly created dollars that earn interest.

Imagine if we each had a relatively modest $1 million line of credit at 0.25% interest from a central bank that we could use to issue loans of $19 million. Let’s say we issued $19 million in home loans at an annual interest rate of 4%. The gross revenue (before expenses) of our leveraged $1 million would be $760,000 annually --let’s assume we net $600,000 per year after annual expenses of $160,000. (Recall that the interest due on the $1 million line of credit is a paltry $2,500 annually).

Median income for workers in the U.S. is around $30,000 annually. Thus a modest $1 million line of credit at 0.25% interest from the central bank would enable us to net 20 years of a typical worker’s earnings every single year. This is just a modest example of pyramiding wealth.

Next let’s say we each get a $1 billion line of credit which we leverage into $19 billion in loans earning 4%. Now our net annual income is $600 million, the equivalent income of 20,000 workers. We did nothing to improve productivity, nor did we produce any goods or services. We simply used the power of central banking and fractional reserve lending to skim $600 million in financial rents from those actually producing goods and services.

Note that we are not uniquely evil or avaricious in maximizing our private gain from the central bank system; we're simply responding rationally to the system’s incentives.

The system concentrates wealth and subverts democracy not because participants are different from the rest of us but because they are acting rationally within a perverse, exploitive system. Would you turn down $600,000 a year? How about $600 million a year?

It makes no sense for banks and financiers not to maximize their gains in this system. Those who fail to maximize their gains will be fired.

I hope you understand by now that the current system of issuing money and credit benefits the few at the expense of the many.The vast privilege and the equally vast inequality it generates is the only possible output of the system.

This inequality cannot be reformed away; it is intrinsic to centrally issued money and private banking with access to central bank credit.

The problem isn’t fiat money; it’s centrally issued money/credit that is distributed to the few at the expense of the many. If we want to limit the subversion of democracy and reduce wealth inequality, we must decentralize and democratize the issuance and distribution of money.

In the current system, money isn’t created to reward increasing productivity. It is created to increase the wealth and power of the privileged.

If we want to connect the creation and distribution of money/credit with productivity, we must issue new money directly to those creating value and boosting productivity, bypassing the privileged few in central and private banks.

By concentrating wealth and power, centrally issued and distributed money doesn’t just subvert democracy. It also optimizes inequality, monopoly, cronyism, stagnation, social immobility and systemic instability.

The status quo "solution" is Universal Basic Income (UBI), a form of subsistence designed to quell the righteous urge to throw off the monetary yoke of the privileged financial Elites. If scraping by as a debt-serf on UBI is the New American Dream, we need a new economic/social system.

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